A specialist is said to be someone who knows more and more about less and less until he knows everything about nothing.
That’s the way it is with some Exchange Traded Funds. By constructing ever-more-specialized indices, these investment vehicles become so focused and targeted as to lose sight of the original premise of a mutual fund—diversification. The point of any fund is to pool your money with other investors so you can efficiently buy a group of stocks rather than just one or two.
But the makers of some ETFs didn’t get that memo when they started to elaborate their business model. The first ETFs were indeed based on broad market aggregates like the S&P 500. Then they expanded into foreign markets, and then sectors of the market, like small-caps or financial stocks.
The motive for all of this is fees, of course. Smaller funds attract a dedicated audience who will supposedly be willing to pay higher fees. If the ETF attracts enough interest, those fees can become substantial. But if the funds just languish, or if the fund company just doesn’t find them profitable, the ETF will be liquidated and investors will find themselves either with a lot of small holdings or get saddled with closing costs.
Such was the case recently with the Luxury Retail ETF, ROB. It was focused on the high-end retail brands like Hermes and Wynn Resorts. But the fund only grew to $17 million, and the fees it generated weren’t enough for it to pay its way. So its sponsor, Claymore Funds, shut it down. Now investors have to figure out what to do.
That’s a little-known risk of ETF investing. Because the fund’s parents matter. It’s not just what you make. It’s what they keep.
Douglas R. Tengdin, CFA
Chief Investment Officer
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